On January 13, 2021, the Internal Revenue Service (“IRS”) and the U.S. Treasury Department (“Treasury”) issued the official version of Final Treasury Regulations (the “Final Regulations”) providing guidance under the “carried interest” rules of Section 1061 of the Internal Revenue Code of 1986, as amended (the “Code”).1 The Final Regulations address a number of previously open questions regarding the scope and implementation of Section 1061 which was enacted as a part of the 2017 Tax Cuts and Jobs Act. The Final Regulations in large part adopt the Proposed Treasury Regulations previously issued on July 31, 2020 which provided preliminary guidance under such “carried interest” rules (the “Proposed Regulations”). The Proposed Regulations are discussed here. The Final Regulations do, however, contain a few substantive changes to the Proposed Regulations. Taxpayers involved in enterprises that issue carried interests (e.g., private equity funds, hedge funds, real-estate funds, and energy funds) should carefully review the Final Regulations.
Key Points of the Final Regulations
1. The Final Regulations confirm that once a partnership interest is subject to Section 1061 it remains subject to Section 1061 unless and until a specific exception applies.
2. The Final Regulations confirm the view of Treasury that Section 1061 recharacterization applies to carried interests held by “S corporations,” and further expand this covered group to include certain “PFIC” entities.
3. The Final Regulations confirm that certain types of income or gains are excluded from Section 1061, notably Section 1231 gains and Section 1256 marked-to-market capital gains.
4. The Final Regulations adopt an exception for “capital interests” held by service providers that is somewhat broader than the exception reflected in the Proposed Regulations. For purposes of this exception, a “capital interest” generally does not include any portion acquired using a loan from the partnership, another partner or a related person but may include portions acquired using a loan from another partner or any related person (other than the partnership) so long as the “borrower” partner is personally liable for such loan.
5. The Final Regulations may recharacterize as short-term capital gain all or a portion of the gain on the sale of a holder’s carried interest even if the holder held such interest for longer than three years based upon certain look-through rules; provided that such look-through rules contained in the Final Regulations are intended to be narrower in scope than the look-through rules reflected in the Proposed Regulations.
6. The Proposed Regulations contemplated that a transfer of a carried interest to a related party would be subject to current taxation even though the transfer may have otherwise been nontaxable (for example, a gift).The Final Regulations amend this approach and provide that taxation will not be accelerated on an otherwise nontaxable related party transfer. Even so, related party transfers may still be subject to greater taxable income at short-term rather than long-term rates.
Brief Overview of Section 1061
Section 1061 recharacterizes certain long-term capital gains as short-term capital gains (generally taxed at less favorable rates) when allocated to taxpayers that hold, directly or indirectly, an “applicable partnership interest” (an “API”), which is the Section 1061 term for what is often referred to as a carried interest. An API for this purpose is generally defined as a partnership interest that is transferred to or held by a taxpayer in connection with the performance of substantial services (by the taxpayer or a related party) with respect to an “applicable trade or business” (generally raising or returning capital and providing investment management services – an “ATB”). Section 1061 extends the holding period required to achieve long-term gains status for a covered disposition from one year (under current law for long-term capital assets) to three years, thus requiring a longer investment period in order for the holder of an API to benefit from the long-term capital gains rates.
Primary Changes to the Proposed Regulations
While the Final Regulations largely adopt the Proposed Regulations, there were four primary areas of changes made to the Proposed Regulations including (1) the capital interest exception, (2) the treatment of capital interests acquired with loan proceeds, (3) the look-through rule for certain API dispositions, and (4) transfers of APIs to certain related persons.
Capital Interest Exception -- The Final Regulations provide for a revised rule that looks to whether allocations are commensurate with capital contributed. This rule expands the definition of capital interest allocations as contained in the Proposed Regulations. Under the Final Regulations, an allocation will be considered a capital interest allocation (and thus excepted from treatment as an API) if the allocation to the API holder with respect to its capital interest is determined and calculated in a similar manner to the allocations with respect to capital interests held by similarly situated unrelated non-service partners who have made significant aggregate capital contributions. Unrelated non-service partners will be treated as having made significant aggregate capital contributions to the extent such partners possess five percent or more of the aggregate capital contributed to the partnership at the time the allocations are made. The Final Regulations do not address situations where unrelated non-service partners in the aggregate do not hold at least five percent of the aggregate capital contributed.
The determination of whether partners are similarly situated may be made on an investment-by-investment or class-by-class basis. The Final Regulations specifically provide that an allocation to an API holder will not fail to qualify solely because:
The Final Regulations retain the requirement that allocations with respect to contributed capital be clearly identified under both the partnership agreement and the partnership’s books and records as separate and apart from allocations made to the API holder with respect to its API, and specify that the books and records must be contemporaneous. The Final Regulations do not provide for the grandfathering of any existing partnership agreements. Allocations made to an API holder that do not meet the requirements of the Final Regulations will not be considered capital interest allocations. Taxpayers will need to determine whether any of their existing partnership agreements should be amended to comply with these standards.
Capital Interests Acquired with Loan Proceeds -- The Final Regulations contemplate that capital contributions made by a service partner with loan proceeds from another partner or a person related to such partner (other than the partnership) may qualify for the capital interest allocation exception so long as the individual service provider is personally liable for the repayment of such loan. Under the Final Regulations, the loan must be fully recourse to the individual service provider, the individual service provider cannot have any right to be reimbursed by any person, and no person may guarantee the individual service provider’s loan. Treasury and the IRS, however, continue to study the treatment of guarantees generally in light of questions about who the borrower is for federal tax purposes.
Look-through Rule for Certain API Dispositions -- Both the Final Regulations and the Proposed Regulations provide for certain look-through rules that can apply when the holder of an API with a holding period greater than three years disposes of the API in either a direct or indirect (i.e., when the API is held through one or more passthrough entities) sale resulting in all or a portion of the gain on such sale being subject to taxation at short-term rates. The Proposed Regulations contained a substantially all test to determine the applicability of the look-through rules based upon whether 80% or more of assets held directly or indirectly by a passthrough entity have a holding period of three years or less. The Final Regulations replace this substantially all test with a rule that the IRS believes more narrowly targets taxpayers that appear to be engaged in abusive practices to avoid section 1061(a) recharacterization. The look-through rules under the Final Regulations apply to situations where either:
For purpose of clause 1. above, a substantial legal obligation to contribute money or property is an obligation to contribute a value that is at least five percent of the partnership’s total capital contributions determined as of the time of the API disposition. The IRS’ stated concern is that without this rule, fund managers might attempt to avoid the recharacterization of gains by establishing partnerships and leaving them inactive for three years before attracting investment from limited partners. The application of this five percent rule may have some unexpected results to the extent any new obligations to contribute capital contributions have been made in the three years prior to an API disposition. Further, it is somewhat unclear whether valuation increases or decreases after the relevant contribution may or should be considered when making this determination. Taxpayers will need to carefully consider the applicability of the look-through rules upon any API disposition.
Transfers of APIs to Related Persons -- The Proposed Regulations contemplated the acceleration of taxable gain upon the transfer (including otherwise non-taxable transfers) of an API to certain “related persons.”2 The Final Regulations reflect a change in position on this treatment. The IRS determined that while Section 1061(d) can be interpreted as an acceleration provision, in the absence of clear language to the contrary, it is more appropriate to apply Section 1061(d) only to transfers in which long term capital gain is otherwise recognized. To address this, the Final Regulations added the term “Section 1061(d) Recharacterization Amount” which represents an Owner Taxpayer’s (defined below) share of the amount of net long-term capital gain from assets held for three years or less that would have been allocated to the Owner Taxpayer upon a hypothetical liquidation of the partnership (or portion thereof). Under the Final Regulations, upon a sale or exchange of an API to a “related person” pursuant to which gain is recognized by the Owner Taxpayer, the lesser of (i) the amount of net long-term capital gain recognized by the Owner Taxpayer upon the transfer of such interest, or (ii) the Section 1061(d) Recharacterization Amount will be recharacterized as short-term capital gain. The Final Regulations also provide for some consistency in the determination of the gain to be recharacterized by incorporating certain exceptions found in other sections of the Final Regulations.3 The Final Regulations further clarify that for purposes of Section 1061(d), an Owner Taxpayer will be treated as transferring the Owner Taxpayer’s share of any indirect API or distributed API if the indirect API or distributed API is transferred by the API holder to a person that is a “related person” for purposes of Section 1061(d) with respect to the Owner Taxpayer.
Other Changes to the Proposed Regulations
The Final Regulations revised the Proposed Regulations to taxpayers’ advantage by modifying the formulas used to determine the amount of income associated with an API that its holder must treat as short-term capital gain under Section 1061 (the “Recharacterization Amount”). Such modifications include allowing for capital losses to be factored into the formula. This will allow for capital losses to be utilized where an Owner Taxpayer holds multiple APIs with both loss and gain.
The Final Regulations continue to treat distributed API property as subject to section 1061(a), however, the Final Regulations provide for the exclusion from the calculation of the API one year disposition amount of items that are treated as capital gain without regard to the holding period requirements of Sections 1222(3) and (4) such as so-called Section 1231 gains, qualified dividend income, Section 1256 marked-to-market capital gain, and capital gains and losses characterized under the mixed straddle period rules of Section 1092(b). This exclusion allows for the incorporation of similar exceptions to API treatment found in other sections of the Final Regulations.
The Final Regulations do not include certain partnership transition amount rules contained in the Proposed Regulations4 as they were determined to be unnecessary.
The Final Regulations revise certain reporting rules. Under the reporting rules, if an Owner Taxpayer is not furnished the relevant information for a passthrough entity or is not otherwise able to substantiate the information, the Owner Taxpayer’s Recharacterization Amount may be increased due to loss of certain exceptions in the calculation of such Recharacterization Amount. Further, in the event certain information is to be provided by a passive foreign company with respect to which the shareholder has a QEF election (as described in Section 1295(a)), the Owner Taxpayer may not be permitted to separately substantiate the information. Taxpayers will want to ensure that their API investments are required to furnish the appropriate information.
Notable Areas Where Changes Were Not Made
Definition of Taxpayer -- The Final Regulations retain the definitions of “taxpayer” contained in the Proposed Regulations. Section 1061 uses but does not define the term “taxpayer,” causing some uncertainty as to how its provisions should apply to partners who hold interests in passthrough entities which themselves hold an API. The Proposed Regulations clarified that for such purposes the term “taxpayer” includes both a person subject to tax on the net gain with respect to an API (referred to as an “Owner Taxpayer”) and passthrough entities that hold an interest in an API (referred to as a “Passthrough Taxpayer”). Owner Taxpayers generally include individuals, simple and complex trusts, and estates. Passthrough Taxpayers may include (i) the entity service provider, (ii) a person related to the service provider, (iii) entities engaged in an ATB, or (iv) the recipient of an interest in connection with the performance of substantial services in an ATB.
Section 1231 Gains -- The Final Regulations adopt the position in the Proposed Regulations that items that are treated as capital gain without regard to the holding period requirements of Sections 1222(3) and (4) are excluded from Section 1061. This includes so-called Section 1231 gains, qualified dividend income, Section 1256 marked-to-market capital gain, and capital gains and losses characterized under the mixed straddle period rules of Section 1092(b).
Treatment of S Corporations -- The Final Regulations, like the Proposed Regulations, also confirm the view of the IRS that Section 1061 recharacterization applies to carried interests held by “S corporations.”
Expansion of Partnership Interest to Include Other Financial Instruments -- The Final Regulations retain the concept set forth in the Proposed Regulations that certain financial instruments that do not constitute partnership interests for general income tax purposes could be treated as an API if the value of such instrument is determined in whole or in part by reference to the underlying partnership. However, Treasury and the IRS continue to study the impact of section 1061 on the taxation of enterprise value related to the transfer or exchange of partnership interests and management contracts.
Substantial Services Presumption -- The Final Regulations retain the Proposed Regulations’ presumption that all services provided for a partnership interest are substantial services for purposes of Section 1061. However, Treasury and the IRS will continue to study and consider possible circumstances under which the presumption might be rebutted as well as the possibility of providing safe harbors for circumstances under which the presumption will not apply.
Third-Party Purchaser Exception -- The Final Regulations do not expand the third-party purchaser exception to API treatment to include non-sale transfers (such as contributions to a passthrough entity holding an API in a nonrecognition transaction). The Final Regulations do, however, in an attempt to reduce uncertainty add a clarifying exception to Section 1061 providing that the term API does not include an interest in a partnership that would be treated as an API but is held by a bona fide purchaser of the interest who does not currently and has never provided services in the relevant ATB and who is not related to a person who provides services currently or has provided services in the past.
Areas Still Under Review
The introductory summary to the Final Regulations specified several areas that Treasury and the IRS are continuing to study including the following:
1. All “Section” references herein are to the Code.
2. Both the Final Regulations and the Proposed Regulations define a “related person” for Section 1061(d) more narrowly than a related person for purposes of the rest of Section 1061. It includes only (i) the taxpayer’s family (i.e., spouse, parents, children and grandchildren), (ii) the taxpayer’s colleagues (those who provides services within the current calendar year or the preceding three calendar years in any ATB in which the taxpayer performed a service), and (iii) any passthrough entity if a member of the taxpayer’s family or colleague is an owner.
3. The Section 1061(d) Recharacterization Amount specifically does not include items that are treated as capital gain without regard to the holding period requirements of Sections 1222(3) and (4) such as so-called Section 1231 gains, qualified dividend income, Section 1256 marked-to-market capital gain, and capital gains and losses characterized under the mixed straddle period rules of Section 1092(b).
4. Such partnership transition amount rules contemplated allowing partnerships in existence as of January 1, 2018 to irrevocably elect to treat all long-term capital gains and losses recognized from the disposition of all assets held by the partnership for more than three years as of January 1, 2018, as partnership transition amounts.
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